Start-Up Dilemma: To Sell Or Not To Sell

There is almost nothing more exciting – or debilitating – than the acquisition offer received by an early-stage company. It is generally the single most polarizing event in a start-ups young life, often pitting acquirer vs. investors, founders vs. investors and founders vs. founders. It is an event that must be handled with great care or else the process can leave lasting scars on an organization, its founder dynamics and its morale.

The investor perspective is heavily informed by the types of investors in the syndicate. If, for example, a company has only taken angel financing, the economics of an early exit can often be compelling for both founders and investors. For a company that has taken in $1.5 million at a $5 million post-money valuation (angels hold 30% of the company via the seed round) and receives a $20 million offer, the angels get a quick 4x return while the founders collect $14 million pre-tax dollars. Not too shabby. While more professional angels might balk at such a quick sale, others will likely chalk up the win and recycle the gains into new investments. The founders, meanwhile, just pocketed a nice chunk of cash. For the first-time entrepreneur, this is surely a life-changing event and one which lays the foundation for a career of less stressful risk-taking now that the house is paid for and the college fund is overflowing. Even if the founders started the company with the goal of building a massive enterprise, a real offer with real cash and real wealth creation is enough to flip more than a few founders from idealist to pragmatist. And the founders have to be honest about this and the investors need to be ok.

The dynamic is certainly different in two particular cases: (1) when there are institutional investors; and (2) when founders disagree on whether or not to sell.

Institutional investors simply have a higher bar than almost any angel, partly because they are investing more significant dollars and partly because of the way fund economics work. Venture GPs are looking for a “cash on cash” return that represents a multiple of their firm’s committed capital. A good return for an early-stage fund is, say, 3x. What this means is that if the GPs are investing out of a $100 million fund, they need to return $300 million to their limited partners. But let’s take this a step further – what does a GP need to do to generate $300 million in gross exit proceeds? Let’s assume for the moment that the fund’s average ownership percentage is 15% at exit. The math is then to calculate the amount of exit value that when multiplied by 15% gives a 3x cash-on-cash return (or $300 million in our example). The answer? $2 BILLION. And this from a little $100 million fund. The numbers get linearly daunting as committed capital goes up. So those little 3-5x exits that many founders find appealing? No so appealing to a venture investor if they feel the company has the potential to really scale. While few seed documents have exit limitations (or a protective provision that requires an investor owning a specific amount of a class of shares to approve a liquidity event), Series A and B documents often do, but at least in my experience in the current market are generally tethered to a minimum exit threshold (say 3x the post-money valuation of the prior round). Regardless, the most important input to an investor’s thinking around a potential exit is the mental state of the founders: do the founders have the passion, resolve and risk tolerance to “go big or go home” or would they rather take the win and move on?

But in start-ups as in life, situations are rarely black-and-white. Are the founders in it for the big win? Well, I have often experienced co-founders to have divergent views on the topic when faced with a real-live offer, and this has created unavoidable friction. Perhaps one founder has made money through a prior exit and views this as their big chance to change the world (and has the resources to not sweat the risk). Maybe the founder is young, has few attachments and doesn’t view winning as tightly calibrated to money: they might want to go big out of ego and raw passion (and simply don’t care about the risk or value the near-term financial payoff). I have seen these same dynamics played out between a sole founder and a key employee, where the founder is conflicted partly because of the financial position and life circumstance of the key employee. In this case it is hard to unpack what the founder really wants to do and what they might do to help out a colleague in need. And it’s not always as easy as waving a wand and providing a measure of founder liquidity. I am a proponent of providing some level of founder liquidity when a company is in scaling mode and where significant revenues are being generated. But more often than not the most vexing M&A decisions come prior to significant revenue generation, making the founder liquidity often premature. There are always exceptions, but I am framing the issue in the way I most often see it in real life.

So let’s say we’re in the gray zone (as one is 90%+ of the time), and an indication of interest from a potential acquirer is high enough to warrant real consideration. This generally precipitates a process where the acquirer wants to conduct due diligence, often starting with meeting members of the team. This is where things get tricky. Not only does the CEO get sucked into the vortex of due diligence management (which necessarily means not selling, recruiting and spending time with customers), but it raises the anxiety level of the team who now become aware of a potential suitor. This can have a marked impact on firm morale and performance. Further, potential acquirers also see the opportunity to build relationships with key engineers and other valuable members of the company, laying the foundation for a potential talent raid in the event the M&A deal doesn’t go through. In short, giving potential acquirers too much access before the Board determines an M&A event is desirable places the entire company at risk. This is why even entertaining an M&A offer is a huge decision. It represents time taken away from building the business as well as the risks associated with a failed process.

Great young companies will always have hungry acquirers knocking at their door. Whether for talent alone or for talent plus an attractive business with early traction, young companies are on the attractive end of the risk/reward continuum due to the relatively low purchase price relative to their potential. This means, of course, that a good deal for the buyer must mean less than a good deal for the seller. Then why do such deals get done? Because as discussed above, the utility functions of the buyer and seller often look very different. My advice to young companies and their Boards is to be open and honest about goals and objectives, acknowledging that these may change in the face of a real-life offer. And if utility functions between founders or among founders and investors don’t mesh, then having an open and honest dialogue is the only way to protect the company and maximize shareholder value.

Roger is an active early-stage investor, having seeded or invested in over 20 companies in asset management, financial technology and digital media since 2004. Prior to his venture days Roger spent 18 years on Wall Street in M&A, Derivatives and proprietary trading.

Throughout his career he has held numerous executive positions, including:

President and CEO of DB Advisors LLC, a wholly-owned subsidiary of Deutsche Bank AG. His 130-person team managed over $6 billion in capital through a twenty-strategy hedge fund platform with offices in New York, London and Hong Kong.

Managing Director and Co-head of Deutsche Bank’s Global Strategic Equity Transactions Group. In 2000, his team won Institutional Investor magazine’s “Derivatives Deal of the Year” award.

As an Investment Banker and Managing Director at Citibank, he held a variety of roles and responsibilities in the Global Derivatives, Capital Markets, Mergers & Acquisitions and Capital Structuring groups.